The Current Model of Islamic Banking and ... Pakistan. For this purpose, Islamic banking department

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  • NUST JOURNAL OF SOCIAL SCIENCES AND HUMANITIES

    Vol.5 No.1 (January-June 2019) pp. 43-62

    The Current Model of Islamic Banking and Concentration

    of Wealth

    Waqasul Hassan* and Anwar Shah†

    Abstract:

    The eradication of the concentration of wealth is one of the prime objectives

    of Islamic finance. Many scholars have written on this issue, who claim that by

    eradicating interest from the society, we will be able to minimise the concentration of

    wealth in an economy. This study conjectures that interest-free finance is a necessary

    but not sufficient condition for the eradication of concentration of wealth. The sufficient

    condition is to bring change in the objective of the Islamic banks that is, switching the

    moto from the maximisation of the profit to the maximisation of welfare of society. This

    paper states that the main focus of Islamic banks is to transform the current models of

    interest based transactions to interest free transactions. However, merely changing the

    transactions from interest based to interest free might not be enough to achieve the

    main objective of Islamic finance. The study compares the assets side of Islamic and

    conventional banks to provide support in favour of the hypothesis that with current

    objective of profit maximisation, the Islamic banks are less likely to play any role in the

    eradication of the concentration of wealth.

    Keywords: Circulation of Wealth, Islamic Finance, Participatory

    finance, Interest rate.

    1. INTRODUCTION

    Wealth plays a key role in the development of an economy.

    However, it is not the production of wealth that matters; it is the

    circulation of wealth that is important for an economy. For this purpose,

    conventional economics has developed a financial system to ensure the

    circulation of wealth within an economy [Mishkin (2004)]. The main

    objective of such financial system is to ensure the channelisation of

    money from surplus unit (savers) to deficit units (Investors). Such

    channelisation takes place either directly through money and capital

    markets or indirectly through financial intermediaries such as banks etc.

    * Waqasul Hassan is Graduate, School of

    Economics, Quaid-i-Azam University, Islamabad, Pakistan. † Anwar Shah is Assistant Professor, School of Economics, Quaid-i-Azam University, Islamabad, Pakistan.

    mailto:anwar@qau.edu.pk

  • 44 Hassan and Shah

    The main lubricant for the flow of money from the surplus unit

    to the deficit unit in the conventional financial system is interest. Banks

    pay interest to depositors and receive interest from investors. One of the

    main outcomes of interest based financial system is the concentration of

    wealth in economies. The reason is that funds are not allocated on the

    basis of productivity in economy; rather it is allocated on the basis of

    credit worthiness. Hence, large corporations and businesses enjoy access

    to funds and earn billions. New but productive investors are denied

    access as they do not have collaterals. Thus, interest based financial

    system is structurally flawed to solve the issue of the concentration of

    wealth.

    Is there any solution of this issue of the concentration of wealth?

    The answer is yes provided that interest is declared illegal. In this regard,

    economic system based on the tenants of Islam provides an ideal solution

    for the problem of concentration of wealth. First, Islam declares interest

    illegal.1

    Next, Islam provides a comprehensive alternative for the flow of

    money from savers to investors without interest. These alternatives are

    in the form of three main modes of financing. The first alternative is trade

    based and includes “Murabaha” “Bai Salam” and “Bai Moajjal”. The

    second alternative is leasing based, mainly including “Ijara” and the

    third alternative is participatory based, that includes “Mudharabah” and

    “Musharkah”.

    Based on the tenets of Islam, a large industry has emerged in the

    world in general and Islamic countries in particular to provide Islamic

    finance in the market. Pakistan has also initiated Islamic finance since

    1979 and was among the first three countries with interest free banking.

    However, the system could not move successfully due to lack of sharia

    guided rules, proper homework at the level of central bank and

    1 The Holy Quran in four different places (surah) mentions the prohibition of interest

    (Riba). Surah Al-Rum, verse 39, Surah Al-Nisa', verse 161, Surah Al 'Imran, verses

    130-32 and Surah al-Baqarah, verses 275-81. Likewise, different sayings of the Holy

    Prophet Muhammad (PBUH) mention the prohibition of interest: For example, as

    Hazrat Jabir (RA) states that The Prophet (PBUH) cursed the receiver and the payer of

    interest; the one who records it and witnesses of the transaction and said: "They are all

    alike [in guilt].

  • The Current Model of Islamic Banking 45

    unacceptability of sudden shifts for banks from conventional to Islamic

    modes.2

    Hence, Islamic banking was re-launched in Pakistan in 2001 after

    removing the above mentioned deficiencies by the Government of

    Pakistan. For this purpose, Islamic banking department in State Bank of

    Pakistan (SBP) was established in 2003. This department aims to

    enhance and strengthen sharia compliance finance in Islamic Banks.

    Over time, five full-fledged Islamic banks and fourteen conventional

    banks with Islamic banking branches started operating in Pakistan.3

    It is pertinent to mention that the main mode to ensure the

    circulation of wealth in Islam is participatory based financing that is

    “Mudharabah” and “Musharkah”. The reason is that it leads to effi-

    ciency as well as equity, simultaneously. Efficiency comes as in

    participatory financing funds transfer from one person to another based

    on productivity and not on the basis of creditworthiness leading to

    increase in the level of production of wealth. Equity comes as both

    parties distribute profit according to the predetermined agreed ratio.

    Moreover, in case of loss both bear the loss and economy is relieved from

    passing the responsibility to other people in society. Nevertheless,

    Islamic finance industry prefers sale based transaction and that too

    “Murabaha” instead of doing participatory based financing. The data

    show that the share of Mudharabah has decreased while that of the share

    of Murabaha has increased over time in the Islamic banking industry

    within Pakistan and across the world (see for example, Islamic Banking

    Bulletin by State Bank of Pakistan). Hence, one can claim safely that

    Islamic banks are playing very passive role in minimizing the

    concentration of wealth within an economy.

    Why is this the case? Some scholars have highlighted the reasons

    that why Islamic banks is not playing a role in minimizing the

    concentration of wealth. For example, Razi (2014) reports that the lack

    2 State Bank of Pakistan (http://www.sbp.org.pk/departments/ibd.htm). 3 List of full-fledged Islamic Banks are: Meezan bank, Al Barakah Islamic Bank, Bank

    Islamic, Dubai Islamic bank and Burj Bank limited. While the list of banks with Islamic

    braches are: Habib Bank, Askari Bank, National Bank of Pakistan, Muslim Commercial

    Bank, United Bank Limited, Bank Al-Habib, Dawood Islamic Bank Limited, Standard

    Chartered Bank, Emirates Global Islamic Bank, Bank Al-Falah., Summit Bank, Bank

    AL-Habib Limited, The Bank of Khebar.

  • 46 Hassan and Shah

    of regulations for Islamic banking in Muslim countries is playing a role

    in the concentration of wealth. Dar and Presely (2000) show that agency

    problem, lack of property rights, and tough competition from conven-

    tional banks determine this failure. Abdul and Sarker (1999) considers

    the issue of principle agent as the major cause of the low level of

    participatory financing. However, to our knowledge researchers have

    given little attention to the motive of profit maximization of banks as one

    of the possible factors in the concentration of wealth. In this paper we

    aim to fill this research gap.

    This study adds in the current literature in the sense that the

    motive of profit maximisation in Islamic banks herself is the main reason

    for the concentration of wealth. We are of the view that Islamic finance

    industry has entered the market with the objective of profit maxi-

    misation. Hence, there is no difference in the objective of conventional

    and Islamic banks. The only difference is that conventional industry does

    not take into account the compatibility of any modes with Islamic

    teaching while the latter tries to give due r